IPA, 2006 - 19th Annual Convention Proceedings, 1990

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IPA 90-227
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PROCEEDINGS INDONESIAN PETROLEUM ASSOCIATION

Nineteenth Annual Convention, October 1990
RISK ANALYSIS AND ECONOMIC EVALUATION IN CAPITAL INVESTMENT
USING SIMULATION TECHNIQUES
Hayu Susilo Prabowo"
Entang Hadisasmita"

ABSTRACT

Calculating prospect or well economics and using

profitability criteria is a step that decision makers have
taken. These criteria provide a measure of prospect or
well profitability such as rate of return, payout time,
and net present value. When the analyst has a good
understanding of his data and there is very little
uncertainty, these profitability indicators can be used
confidently to evaluate and select prospects or projects.
However, when uncertainties in the data are high, these
criteria are a poor measure of investment worth because
they do not provide a quantitative estimate of the
chance or probability of achieving a certain economic
value. The next logical step in evaluating investments
which exhibit a high degree of uncertainty in the data is
to add statistical techniques to the evaluation process.
Simulation techniques provide an extremely yet
conceptually straightforward, way to solve problem.
The basic idea of simulation consists of building a
conceptual model of the uncertain real-world problem
being studied combined with economic sensitivity
analyses to produce a statistical estimate of the
profitability of a certain prospect or project. The results
of a simulation study, a profit distribution, provide a
convenient way to graphically portray to management
all of the possible outcomes of the decision option.

Rate of return calculation basically provides the answer

for the first question. It uses generally accepted "time
value of money" concepts and provides numbers for use
in the inevitable judgement decision.
Payout time of a project is defined as the length of the
time required to receive accumulated net revenues
equal to investment. It tells the decision maker nothing
about the rate of earnings after payout time and does
not consider the total profitability of 'the investment
opportunity. Consequently, it is not a sufficient
criterion in itself to judge the worth of an investment.
The profit criterion of net present value is similar to rate
of return except that a single, previously specified
discount rate is used for all economic analyses. The
single discount rate is usually called the average
opportunity rate, and presumably represents the
average earnings rate at which future revenues can be
reinvested.
All of the measures of investment worth that have been
discussed thus far are "no-risk" parameters. That is they
do not include explicit statements about the degree of
risk of the investment. The need to consider risk arises
whenever more than one outcome is possible from a
given investment decision. Drilling investments certainly fall into this category. In fact, we will see that risk is
probably the most critical factor in the decision.

ENGINEERING ECONOMIC YARDSTICK

The engineering appraisal must provide answers to at

least several questions. Is the rate of cash flowback
commensurate with ,the needs of the investor and the
risk involved? How long will it take to return the capital
invested? How much new capital will the investment
generate? What is the probability of a successful
investment?

* Virginia Indonesia Company

RISK ASSESSMENT

Decision to invest capital in oil business always include

risk and uncertainty. Virtually all of. the important
investment decisions we have made over the years were
taken without knowing exactly what the outcome would
be in terms of profits and losses. In most of these
decisions the element of risk was probably recognized,
but the usual practice has been to more or-less account
for risk by adjectives and/or use of minimum acceptable
profitability levels (rates of return, payout, etc.) where

410
the profit criteria were computed on a no-risk basis as if
the well were certain to be a discovery.
Typically, we computed rates of return to four or five
place accuracy and then assessed risk with an adjective.
These rather intuitive approaches for decision making
have been, in general, acceptable because historically
the level of risks and capital requirements have been
relatively low.
But times have changed. The shallow, easy-to-define
structures have all been drilled, and we are now
exploring for oil and gas in deeper, harder-to-find types
of traps involving much greater levels of risk and
uncertainty.

international one, there is further political risk of

nationalization, operational restrictions, a royalty
revision, or political unrest in the host country.
In sutnmary (Fig. l ) , the total uncertainty factor is the
product of the technical, economic, and political
subfactors. The future net revenue one might project
from production of the estimated reserve must be
reduced to an expected value using the total uncertainty
factor.
ECONOMIC SIMULATION MODELS

In 1964, Hertz proposed a new approach for the

analysis of risk in capital expenditures called economic
simulation. Within a few years numerous articles began
to appear on the application of simulation to many
diffwnt types of petroleum engineering and exploration analyses. Today the method is being used to
analyze risk and uncertainty on major decisions
(offshore bids, decisions to go into new exploration
areas, etc.) by virtually all major oil companies. And as
more engineers, geologists, and management become
aware of its logic and application, the method is gaining
increasing use in day-to-day decision analyses.

The risks associated with estimating the reserves and

value of a hydrocarbon-producing property are divided
into three classifications: technical, economic, and
political (Garb 1988). Technical uncertainty relates to
whether the hydrocarbon volumes estimated by the
geologists and engineers do exist in the ground and
whether the reserves and recovery rates will be as
projected by the engineers. Technical risk is a function
of howloqg the property has produced and the maturity
and quality of the data base from which the reserves
determinations were developed. The reserves estimates
depend strongly on the accuracy of measurements from
tools that too frequently are inexact. Log- determined
porosity, for example, might truly measure the pore
space of a rock, yet today's logs cannot identify how
much of that pore space is interconnected.

Briefly stated, simulation allows the analyst to describe

risk and uncertainty (variability) in the form of a
probability distribution of possible values each random
variable could have. The simulation method of risk
analysis (Fig. 2) can be described best as a sequence of
steps (Newendorp 1967).

Until recently, technical uncertainties (oil and/or gas,

area, porosity, net pay thickness, water saturation,
producing mechanism, recovery factor , and producing
rate) dominated the concern of our industry, and
determination of the technical uncertainty factor was
usually assigned to engineers and geologists.

1. Estimate the range and distribution of possible values

of each independent variable that will affect ultimate
profitability. This may require the judgement of
several people-the geologist, engineer or economist.
Each would describe the distribution of the variable
about which he is the almost knowledgeable.

In the economic risk, prices can effect the uncertainty in

an exploitation property and also capital and operating
costs. Inflation and interest rates on borrowed capital
also add to our uncertainty. Last, but not least, there is
the subject of market. Even though we may have
substantial reserve and are willing to sell it at a going
price, if there is no market or if the market is extremely
variable, it is difficult to account for the value of money
received in the future during an evaluation process.

2. From the distributions of each variable select at

random one value. Compute the profitability
(discounted net profit, for example) using this
combination of variables. This determines one point
in the final distribution of probability. Select at
random a second value from the distribution of each
variable. Again compute the resulting profitability.
This is a second point in the distribution of
profitability.

Political uncertainty includes local and national taxes,

environmental regulations, and global concerns, e.g. ,
international instability that could disrupt imbalance
levels of imports. Efforts to, stabilize oil prices may take
on the form of import taxes or OPEC production
regulations. If a property being studied is an

3. Repeat the process again and again, each time with a

set of values selected at random from the distribution
of each variable. Enough combinations of variables
should be considered to describe adequately the
shape and range of the distribution of ultimate
profitability.

'

4. The ultimate profitability data can be arranged to

determine the probability of obtaining various ranges
of net profit. Or, by re-arranging on a cumulative
frequency basis, the probability of obtaining at least
a specific profit can be determined.

A random variable is here defined as a parameter

affecting ultimate net profit whose exact numerical
value cannot be measured or determined at the time of
the analysis. Examples in drilling prospect analysis
include net pay thickness, initial well potentials, drilling
costs, future prices, etc. These factors all have an
important bearing on profit, but we are not able to
determine their exact numerical value at the time the
decision is being made to drill the prospect. Simulation
is a useful evaluation tool in these instances because the
entire range of possible values for these parameters can
be included in the analysis of ultimate net profit of the
investment.
The critical step in simulation is to identify the key
variables in the evaluation. Most articles recommend or
imply that we should describe a distribution for each
random variable, and sample from each distribution
separately on each pass. The mistake here is that
sampling each distribution separately on each pass
implies that each variable is independent of all other
random variables. In the analysis of drilling prospects,
however, there are several important random variables
which are not independent of one another. Available
statistical tests should be used on a data sampling to
determine whether the variables are independentie.,
do not depend on one of the other variables being
analyzed. Testing for independence is usually performed by plotting one variable vs. another (Fig. 3).
Totally independent variables will show a complete
random scatter when so plotted. Completely dependent
variables will form a well-defined trend. Partially
dependent variables will plot in an envelope, having
some scatter but showing definite trend. One of the
easiest ways to treat dependent variables is to integrate
them where possible into a single independent building
block. A distribution of recovery factor, for instance,
may intergrate oil gravity, porosity, water saturation,
viscosity, and gas in solution.
It is usual to array the raw data in some manner and to
reduce the amount of raw data, if combersome, so that
they may be segmented into representative groups. A
typical arrangement would be ascending order, with the
total array divided into sufficient groups, so that the
same practical statistical results can be achieved with
the classes instead of with each data point separately.
When classes have been selected and the ordered
elements divided into classes, a frequency curve and a
cumulative frequency curve can be prepared. This is a

plot of the percentage of all observations possesing

values greater or less than the class boundary vs. the
class mark for that group. This distribution curve
defines -the population of that variable.
If insufficient data are available to develop a distribution curve from historical information, one is forced to
use a standard curve found from past experience to
represent the variable being studied. Types of
probability distributions frequently used in petroleum
engineering are symmetrical or bell- shaped curves;
skewed curves, either positively or negatively shifted;
and rectangular curves, where no central tendency is
observed. A simple way of establishing a distribution
curve, if none are available, is to use probability paper.
Maximum and minimum values may be plotted on the
probability paper at 99 and 1 cumulative percentile
points, respectively, and draw a stright line connecting
these points used to define a distribution. If most likely
values have been estimated, triangular distributions can
be processed into a cumulative distribution curve by
simple equations (Garb 1988).
When the variables have been ordered, studied, and
analyzed into distribution curves and profiles, the data
can be entered into the model chosen. After execution
of the model, the answers should be compared with
reality to ensure the success is no better than observed
in the past. Finally, the results of a probabilistic study
should be expressed in the form of a frequency distribution.
FIELD CASE
Virginia Indonesia CompanyRertamina operate two
major gas fields in East Kalimantan. The Badak and
Nilam gas fields provide an average daily supply of over
1.0 BSCF to the Bontang LNG plant and Kaltim
Fertilizer plants. The peak demand of the process
facilities is in excess of 1.6 BCSF.
In this dynamic environment, field development
planning must consider deliverability requirements to
assure steady gas supplies are maintained and efficient
utilization of gas reserves is achieved. The gas reserves
in these fields are found in a geologically complex
deltaic environment. There are in excess of 300
individual gas reservoirs, ranging in depth from 4,000
feet to 15,000 feet. The reservoirs have a wide range of
size, permeability, and compositional make-up.
The stratified nature of the fields results in a lesser cost
development approach of producing the deeper
reservoirs during the early years and the shallow
reservoirs in the later years. This approach is referred to
as a "bottoms-up" depletion strategy. The advantages

412

of this approach are: (1) through the life of the field, a

single wellbore can be\ used for depletion of several
reseqvoirs; and (2) diilling hazards in the later life of the
field are minimized. The disadvantages of this approach
are that the deeper reservoirs tend to have lower
productivity and poor sand continuity development,
and therefore, the development of these reservoirs
require high capital investment besides having a high
degree of uncertainty.
To meet the peak demand conditions, drilling to
shallow (A, B, C, D & E), high permeability, zones
provides gas deliverability at minimum cost, on
condition that there are some deviation in reservoir
management and possible drilling hazards in the later
life of the field.
Many of wells drilled earlier are not deep enough to
penetrate the F, G, and H sands. The few wells that
have penetrated these deeper sands indicate that
substantial gas reserves are present.
To demonstrate the economic simulation techniques in
evaluating uncertainties of drilling one well completed
as a dual gas commingle completion (4 perforated
reservoirs in one well) in the deeper zones, a very
simple simulation procedure was developed. Maximum
and minimum values for gas reserves, initial gas
production rate, and drilling cost were entered with the
most likely values to establish a triangular distribution
of each variable, exponential decline curve was then
applied assuming economic limit rate of 300 MCFD.
Other variables, such as: gas price, operating
expenditure, etc. are considered constant. Then a
number of simulation passes were done, randomly
solving for Rate Of Return and Net Present Value at
20% discount rate. Based on this set of executions,
assuming maximum, minimum, and most likely values
as shown in Table 1, the distribution of answers resulted
in the profit distribution curves (Fig. 4).
The two curves show probability distribution of NPV at
20% discount rate and ROR of the company share.
Both curves were constructed from the results of the
5000 cases run in the simulation.
It shows that the range of possible expected results from
-1 to 2.5 million dollars of NPV at 20% discount rate
and -67% to 23,375% of ROR.
Further examination on the cumulative probability
distribution curve indicates that there is a 90% chance
the drilling program will result in a significant financial
profit.
The simulation analysis provides an important piece of
information that single-case calculations lack: the range

of uncertainty of the answer with respect to the

expected ranges of variables that determine the answer.

CONCLUSIONS
The advantages of the economic simulation analysis in
capital investment decisions presented in this paper may
be summarized as follows:

1. The simulation techniques offers additional

information of the probabilities of occurance of each
level of profit.
2. Each variable affecting ultimate profitability is
systematically combined into a single probabilistic
description and all of the possibility combinations of
outcomes are included in the analysis.
Hertz summarized the problem very well with the
observation that, ... the courage to act boldly in the
face of apparent uncertainty can be greatly bolstered by
the clarity of portrayal of the risks and possible
rewards. The method described herein appears to be a
significant step towards this objective.
ACKNOWLEDGMENTS
The authors wish to express their appreciation to the
management of Virginia Indonesia Company and
Pertamina-BPPKA for their permission to publish this
paper.
REFERENCES
Garb, F.A. 1988. Assessing Risk in Estimating
Hydrocarbon Reserves and in Evaluating Hydrocarbon-Producing Properties. J . Pet. Tech. June,
765-778.
Hertz, D.B. 1964. Risk Analysis in Capital Investment.
Harvard Business Review.
Newendorp, P.D. 1975. A Method for Treating
Dependencies Between Variables in Simulation Risk
Analysis Models. paper SPE 5581.
Newendorp, P.D. and Root, P.J. 1967. Risk Analysis in
Drilling Investment Decisions. paper SPE 1932.
Newendorp, P.D. and Campbell, J.M. -1970. Decision
Methods For Petroleum Investments. John M .
Campbell and Company, Norman, Oklahoma.
Surtiwa and Ellenberger, C.W. 1986. Depletion
Planning for Multi-Reservoir Gas Fields: Development
Techniques and Technical Challanges. Proceedings of
Fifteenth Annual ZPA Convention.

413

TABLE 1.
Data Used in The Example

Init. Prod, Rate, MMCF/D

Gas Reserves, BCF
Drilling Cost, Million$
Condensate Yield
Gas Price
Cond. Price
Operating Cost Gas
Operating Cost Cond.

=
= $

$
=$
=$
=

Min. Most Likely

0.0
1.o
0.0
1.o
3.0
3.3
10 bbl/MMCF
2.2YMCF
18.07/bbl
O.OS/MCF
1.23/bbl

Max
2.0
4.0
4.0

START&

#-------

ENGINfER

CfOLOClST

OR

I-c

EXPECTED VALUE

01 X

U,

POLITICAL,

uD

Uf

Up

GYPSY wiTn
CRYSTAL BALL

OPEC

TAXES
NATIONALIZATION
ROYALTY REVISION

= Projected Present Worth

LCONOMIST Ofl
FINANCIAL ANALYST

mcEs
CAPtlAc COST
OPCRATING COST
INFLATION

ECONOMIC, Ur

EXPLOITATIQN

TOTAL UNCERTAINTY FACTOR, Uf

EXPERT

7 TECHNICAL, Ut

I
I

UNCERTAINTY

'I

FIGURE 1 - Risk and uncertainty in evaluating petroleum exploration and exploitation properties.

I
I
I

RISK

EXPLORATION

415

UNCERTAIN VARIABLES

FIXED VARIABLES
GAS PRICE

Qi

RGIP

OPERATING COSTS
CND. PRODUCTION

DRL COST

RANDOM NUMBERS GENERATOR

PRODUCTION PROFILE GENERATOR

ECONOMIC EVALUATION
/

FREQUENCY DISRIBUTION

\I/
RESULTS

FIGURE 2 - Schematic for economic simulation through value.

.-

FIGURE 3

;
r

'fiin-

Vorjoble x---t x m ~
( c ) Portiolly dependent
voriobles

- Graphic determination of dependency between variables.

Vorioble C(b) Completely dependent

voriobles

Vorioble A
(0) Two independent
voriobles

Boundary within which X ond Y

con occur. (Drown of ter doto
hove been plotted.)

417

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